The Empire Strikes Back

Last week, this newspaper reported that the government is leaning on the Reserve Bank of India (RBI) to ease the prudential guidelines for recognition of non-performing assets (NPAs). Faced with an alarming rise in NPAs and anxious to prevent the resultant squeeze on bank lending, the government wants banks to sweep NPAs under the carpet by the simple expedient of labelling them ‘good’ assets. Even though it knows full well that regulatory forbearance will only postpone the problem and make it more intractable in the days to come!

In the same vein, government is prodding the Insurance Regulatory and Development Authority (Irda) to relax its investment guidelines for insurance companies and allow them to invest in non-AAA-rated securities in a bid to increase the pool of funds available to corporates. Never mind the damage this will do to the long-term viability of the sector! Ironically, both these measures are at odds with the lessons of the 2008 financial crisis that, presumably, demonstrated the perils of regulatory forbearance; of regulators failing to nip trouble in the bud; opting, instead, to ‘pick up the pieces’ after the crash. But the Indian government is not alone.

The world over, governments are not only pushing ahead with untested policies but are also urging regulatory forbearance. And regulators are meekly falling in line. It is true unconventional problems call for ‘unconventional policies’ , as RBI governor D Subbarao put it in his speech on the occasion of the US Fed governor Ben Bernanke’s visit last week. The problem is, unconventional policies could lead us deeper into the woods.

Most newspapers interpreted Dr Subbarao’s reference to Bernanke’s policies as ‘praise’ . But a closer reading of his speech shows the governor was much more guarded, saying , “We will not know for many years whether the policy mix followed to manage the crisis is right.” What we do know, however, is that governments everywhere are opting for the unconventional , the untried and the untested, and are using monetary and regulatory policies to serve their ends. Last week, the UK’s financial sector regulator, following in the footsteps of the European Banking Authority, relaxed capital and liquidity rules on banks in a bid to spur bank lending.

Under the new guidelines , reported in the Financial Times, banks will not be required to hold any extra capital against new loans that qualify for a ‘funding-forlending’ scheme targeted at increasing lending to corporate borrowers. The regulator has also eased new capital rules imposed under Basel-III . Likewise, EU banks have been given the green signal to hold a set amount as capital instead of 9% of their risk-weighted assets as capital. This means they will not need to bring in more capital if they increase their lending. The apparent objective is to prevent rapid deleveraging that would harm economic activity.

But it was precisely the attempt to shore up economic activity regardless of long-term consequences that led to US subprime lending and the troubles that followed. So, is there nothing we have learned from the recent crises ? It would appear so. What is worse is that as the deadline for implementation of the Basel-III norms approaches, there is a flurry of reports on the flaws of Basel-III and the need for regulatory forbearance in one form or other. But it is nobody’s case that Basel-III will end all crises.

All that Basel-III does is to increase the amount of capital banks will need to hold, thereby reducing leverage and, hence, the potential for damage. It was devised by the Bank for International Settlements (BIS), the central bank for central banks, at a time when the G20 was seized with a sense of urgency to look for a way out of the crisis. But now that the immediate apocalypse has been averted, the all-powerful Empire (read: financial sector) is striking back.

The new norms raise the cost of doing business for banks, especially for the larger and more powerful amongst them since they have to hold additional capital as they have been deemed systemically important. The result is a rising tide of objections to the new norms with powerful banks playing on governments’ fears that it will limit lending and growth and, hence, jobs.

The reality is regulatory forbearance always poses a risk. Whether that risk is worth taking is for each country to decide depending on its own circumstances. Unconventional policies and regulatory forbearance might be a worthwhile risk in the US, the UK and Europe, all of which are trying to ward off a double-dip recession. But do we need to follow the west blindly? We are nowhere near a recession, though growth has slowed. More important , the cost of going wrong could be disastrous when we have so many living below the poverty line. Yes, regulatory discipline might reduce bank lending. But that is the whole point of Basel-III : to rein in lending to manageable proportions.